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The Truth About the Dividend Tax

Oh, it's on now! This past July, I proposed that the government would help bring some stability back to the markets if it ceased the practice of double taxation of dividends.

At the time, frankly, I thought this had little chance of happening. Dividend taxation is one of those petty issues that goes unnoticed because people only understand one side of it, and corporations, on the whole, have been pretty loath to send shareholders precious capital. Dividend yields now sit at about 1.7% for the S&P 500 -- not as low as during the most recent boom, but still waaaay below the historic average of about 3% per year.

What's the big difference? Ending the double taxation of dividends is part of a $600 billion economic stimulus package sponsored by President Bush to assist the foundering U.S. economy. In short, Bush is trying a little supply-side economic ploy -- adding liquidity to the system so people spend more cash.

Over the next few days, you'll hear a great deal of specious logic about taxation and the economy in general from people who should know better. I am consistently blown away by many journalists' and politicians' lack of economic education. Ignore the simplistic jargonizing. All of it. Bush is proposing a systemic change. One simply cannot look at the amount of dividends made available by companies today and say, "That's the amount the government is giving out in tax breaks." Well, one could say this, but one would be wrong. And mocked.

What happens when we end the double tax?Economics is about cause-and-effect relationships. In this case, how lowering the taxation on dividends will provide more incentive to spend among the American public and its businesses. Will it work? I can tell you this: We'll probably never know. You're talking about an economic system that's simply too large and too complex, and a tax too hidden to be able to separate it from other variable macro- and microeconomic elements.

That doesn't mean we can't guess. But we should look closely at the logic of the proposal, here. Forget the "tax break to the wealthy" rhetoric -- the IRS's own sources show that American households claiming income of less than $50,000 had dividend income of $26.9 billion in 2001, while those reporting income above $1 million had dividend income of $25.4 billion. Even so, this doesn't matter.

One economist (I wish I'd caught the name so I could make fun of him) argued most seniors -- the class for whom cash generation from investments is traditionally most important -- don't count on stock dividends for much of their income.

Of course they don't. Why would they? Tax policy has created a disincentive for corporations to return profits to the rightful owners of those businesses. It doesn't matter what people do now, but what they would do if the regime changed. Do people really think behavior won't change on the corporate and personal levels when suddenly dividends are as much as 35% more valuable than they were? Already corporate cash hoarder Oracle(Nasdaq: ORCL) said it would consider a dividend in an environment in which it's efficient to have one. No wonder people don't treasure dividends like they once did -- they only get $0.40 on the dollar!

A June 1995 study from the National Bureau of Economic Research tracked the behavior of the same taxpayers before and after the marginal tax-rate cuts passed in 1986. Those who received the biggest rate cut "had the biggest behavioral response." Translation: They spent more, generating economic activity and tax generation in other ways, offsetting the original loss in revenues for the government.

Let's face facts. Dividends are a logical target for tax cuts because doing so corrects a historical imbalance -- an imbalance affecting the 52% of American households that own shares in public companies. This cannot be emphasized enough. Dividends will still be taxed, at the corporate level, by about 35%. That's good revenue for the government. Those who state dividends will now be "tax-free" are ignoring the fact that, previously, they were taxed not once, but twice. I'd like those opposed to dropping the tax on dividends to be a little more honest about their intentions. C'mon, you can say it: "I believe corporations should not return money to their owners."

So, what are the benefits? Sure, there's the "more money in individuals' pockets" argument, which is a big part of the impetus to make this change. But there's more. Much more. I suspect, in the end, these things will be more valuable to the economy than just fattening up individuals' dividend checks. After all, in this age of electronic cash, it's not like I receive dividend checks in the mail. The company pays the dividend to my broker, who reinvests it into the stock, as I have instructed. Others who don't elect to re-invest will simply have more fuel with which to invest in companies.

Plenty of people use dividends for current cash-flow requirements, and this will make a big difference for them. Some companies also have significant cross-holdings of other companies. Imagine a company funding jobs by virtue of an increase in the amount it retains from holdings in other dividend-paying companies.

What's to like?Bush's proposal would offer some crucial benefits. First, Americans will have a greater incentive to invest. If you've ever done a compounding return scale, you'll see that an individual's overall return can be exponentially higher over a lifetime based upon seemingly tiny year-to-year differences.

Increased dividend yields will increase trust in the stock market. At this point, investors don't trust financial statements, and they don't trust that stock buybacks (the preferred alternative to dividends by corporations) are to their benefit. But they can put a whole lot of trust into a dividend check -- the company has to have money for it to clear. This may not be a classical economic efficiency argument; after all, companies should choose to do what returns the most value to the shareholders, be it reinvestment, stock buybacks, or dividends. Truth is, under the uneven treatment of these options, they don't.

Companies will have a much greater incentive to return money to shareholders. As it is, companies' main incentive is to hoard cash, and to use that cash as the surety upon which to take on debt. Companies should always seek the most efficient use of capital -- if they have no good use for a pile of cash, they should return it to shareholders. Removing a disincentive from making this decision on a tax-neutral basis is crucial.

Dividends add ballast to the stock market. If a company with no dividend falls 70% in share price, it's human nature to call it a big risk. It may not be true, but that's the tendency. If a company has a dividend yield of, say, 2% at its peak price, suddenly after such a drop, its yield is 6.67%. A dividend at this level would thus help attract investors. The current tax regime deters such thinking.

An increased dependence on dividends as a way to return equity to investors could improve corporate governance. Some say it would end the practice of share buybacks, except for those companies with insane stock options programs. I disagree. Again, companies should always seek the most efficient use of capital. If management believes shares are the most efficient way to do so -- meaning shares are dirt cheap -- then the company should buy back shares. But it is an abuse of investors to simply amass cash without a plan for it, just as it is to buy back expensive shares simply to counteract stock option dilution.

In an environment in which dividends are once again considered an equally attractive option, companies have the ability, and the responsibility, to make the most efficient decision. They would no longer have an unequal tax regime to justify bad decisions with retained equity.

Yeah, I think removing the double tax is a good idea. The whole double taxation of dividends thing came during the Depression, when both shareholders and companies were desperate to retain cash. It passed as a disincentive for companies to pay dividends. Boy, did it ever work. Doesn't mean it was a good decision for all environments. Now, 70 years later, we might just be on the verge of fixing it.

Bill Mann would like to thank local weathercasters for their accuracy. On Sunday, he shoveled six inches of "partly cloudy" off of his driveway. He owns none of the companies mentioned in this article. He is managing editor ofThe Motley Fool Select, where you can find his best Foolish stock ideas you won't find anywhere else. The Motley Fool has adisclosure policy.